Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?

February 11th, 2010

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Everyone knows that China has US$2.4 trillion of reserves. This has led to many (including some analysts from big financial institution) to believe that such gigantic reserves are akin to ‘cash’ that China can spend its way out of any potential crisis.

Actually, this is one big misconception that this article will address.

The US$2.4 trillion of reserves is only half the picture. Looking at that alone is analogous to looking at the asset column of a company’s balance alone. What’s also important is the liability side of the picture. When you put the two together, then you will get a better idea of how much of the ‘cash’ (i.e. the reserves) that the Chinese government can really spend.

First, we will look at the liability side of China’s ‘balance sheet.’ According to this report from Pivot Capital Management,

… the size of the Government?s debt is vastly understated. Not included in the public debt figures are the liabilities of the local governments, which the Ministry of Finance estimated at $680bn as of the end of 2008. In addition to that, a large part of the loans extended this year (estimated at $350bn) went to finance public infrastructure projects guaranteed by local governments. Furthermore, when the Chinese government bailed out its banking system in 2003, it set up Asset Management Companies that issued bonds to the banks at par for the non-performing loans that were transferred to them. These bonds, worth about $260bn, are explicitly guaranteed by the Ministry of Finance and the Central Bank and sit on the balance sheets of the big four banks. The Chinese government also explicitly guarantees $400bn worth of debt of the three ?policy banks?. In total, these off-balance sheet liabilities are equal to $1.7tn, which would bring China?s public debt to GDP ratio up to 62%, a level that is comparable to the Western European average.

These debt guarantees within the off-balance sheet liabilities are what we call “contingent liabilities.” Australia’s bank deposit and wholesale funding guarantee are examples of contingent liabilities of the Australian government (see Australian government?s contingent liability to exceed AU$1 trillion).

These off-balance sheet liabilities are not the only liabilities. The Chinese currency in circulation is also a liability. Remember what we wrote in How does China ?save?? Story of the circuitous journey of a US$? In that article, we explained how a US dollar travelled from America (in the hands of an American consumer) to China, and then exchanged as RMB and then travelled back to the US as Treasury bond purchases. The crucial intermediate step to examine in this circuitous journey is when the US dollar is exchanged for RMB. As we all know, the RMB is pegged to the US dollar at a specified ratio. Currently, the ratio is at 1:6.833. To simplify matters, let us round up the number to 1:7. What happens (in a very highly simplified form) is that for every US dollar that gets presented to the PBOC, approximately 7 RMB will be issued.

One way to look at it is that the RMB in circulation are ‘backed’ by US dollars in the form of currency reserves. That was exactly the same situation that America faced in the 1920s. Back then, under the gold standard, the US dollar was pegged against gold in the ratio of approximately 1:20. In reality, not every US dollar was backed by gold. In other words, the US dollar was partially backed by gold in the same way your ‘cash’ at bank was partially backed by physical currency and your bank’s deposit on the central bank. That is, there was a theoretical possibility that there could be a run on the Federal Reserve’s gold if every citizen decided to redeem all their currencies for gold at once. In the same way, China’s RMB in circulation are partially ‘backed’ by their US currency reserve. According to the chart provided by Pivot Capital’s report, only a little over 20% of China’s total currency (plus gross external debt) are ‘backed’ by their US dollar reserves, which isn’t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

Of course, in reality, it is unlikely that there’s going to be a run on China’s US dollar reserves. But according to Pivot Capital, since 2007, there are approximately US$500 billion of “hot money” in China that can easily leave the country at a moment’s notice. That US$500 billion is money that China cannot spend and must be ready to meet the ‘redemption’ demand of the “hot money.”

So, in reality, the picture of China’s currency reserves is not as rosy as it seems.

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